Island Investing: Index Funds

A. They are low-cost mutual funds built to mimic a stock market index. For instance, an S&P 500 Index fund contains stocks in the 500 companies that make up that index.

Index funds are passively managed, meaning the fund contains the same stocks in the same proportion as the index being mirrored. An index fund manager does not attempt to subjectively evaluate or select individual stocks.

Approximately 75% of all actively managed mutual funds fail to beat the market – or a simple index fund. Funds that simply match the market’s performance can outperform three quarters of all mutual funds. Index funds enable you to do just that – outperform most mutual funds while paying considerably less in fees.

Over the last eighty years, the stock market has gained on average 11% a year. If you invest $10,000 and earn 11% a year for 50 years, you will end up with $1.85 million. The trick is keeping most of those returns yourself rather than paying high fees to your broker or fund manager. As mentioned last week, the average actively managed mutual fund charges about 2% a year in fees. In the scenario above, paying fees of 2% a year to your fund manager is equivalent to earning 9% instead of 11%. At the end of 50 years, you would then have $744,000 instead of $1.85 million. Fortunately, some index funds have fees of less than 0.20% a year.

If you are not comfortable picking stocks on your own, want to be invested for decades and don’t know a great portfolio manager, you’d need a really good reason to start anywhere other than an index fund. Exchange Traded Funds (ETFs) often make as much sense for investors as index funds, but we’ll cover ETFs later.

Many companies offer index funds, the largest and most well-known being Vanguard. The Vanguard 500 Index Fund (ticker:VFINX) and Vanguard Total Stock Market Index Fund (ticker: VTSMX) have no loads and miniscule expense ratios. You can learn more about both at www.vanguard.com.